WORKING PAPERTHE GREAT RECESSION AND ITS AFTERMATH FROM A MONETARY EQUILIBRIUM THEORY PERSPECTIVE

By Steven G. Horwitz and William J. Luther

No. 10-63 October 2010

The ideas presented in this research are the authors’ and do not represent official positions of the Mercatus Center at George Mason University.

The Great Recession and its Aftermath from a Monetary Equilibrium Theory

Perspective*

Steven G. Horwitz† St. Lawrence University

William J. Luther‡ George Mason University

Version 4.0

Abstract: Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. It is from this latter perspective that we consider the events of the last few years. We argue that the primary source of business fluctuation is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescription to reduce the likelihood that such a scenario occurs again by better ensuring monetary equilibrium and eliminating moral hazard. JEL Codes: B53, E32, E42, E52, E58 Keywords: Austrian economics, bailout, business cycle, FDIC, monetary equilibrium theory, monetary systems, monetary policy, moral hazard, nominal income targeting, The Great Recession

* The authors thank the Mercatus Center at George Mason University for generously supporting this research. † Email: shorwitz@stlawu.edu Address: Department of Economics, Hepburn Hall, St. Lawrence University, Canton, NY 13617 Phone: (315) 229-5731 ‡ Email: wluther@gmu.edu Address: Department of Economics, George Mason University, MSN 3G4, Fairfax, VA 22030 Phone: (740) 222-1242

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Modern macroeconomists in the Austrian tradition can be divided into two

groups: Rothbardians and monetary equilibrium (ME) theorists. The name for the latter is

somewhat misleading, however, as both groups argue that monetary equilibrium is

ultimately achieved where the quantity of money supplied equals the quantity of money

demanded. The difference between these two approaches concerns what should adjust so

that equilibrium is obtained. Rothbardians argue that “any supply of money is optimal,”

provided only that it is above some trivial minimum necessary to conduct transactions

(Rothbard 1988: 180).1 Because Rothbard’s proposal for 100 percent gold reserves ties

the money supply rigidly to the supply of gold, Rothbardians effectively hold the money

supply constant in the short run and thereby rely on price adjustments to bring about

monetary equilibrium in the face of changes in the demand for money.

In contrast, monetary equilibrium theorists argue that an ideal monetary system

would expand or contract the supply of money to prevent changes in the demand to hold

money from affecting its current value. Whereas price changes are typically desirable to

clear markets for goods and services, ME theorists note that money is unique in that it has

no price of its own. Because money is one half of every exchange, changing “the price of

money” to clear the money market requires changing all prices. The economy-wide price

changes necessitated if the price level is to bear the burden of adjustment disrupt the

process of economic coordination and lead to macroeconomic instability and either a

deflationary recession or inflation and a potential boom-bust cycle. These significant

1 Rothbard (1988: 181) makes his position quite clear: “There is never any social benefit to increasing the quantity of money, for the increase only dilutes the ‘objective exchange value,’ or purchasing power, of the money unit. Monetary calculations and contracts are distorted, and the early recipients of the new money, as well as debtors, gain income and wealth at the expense of later recipients and of creditors. In short, increasing the quantity of the money is only a device to benefit some groups in society at the expense of others.”

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costs of changing all prices to reflect a change in the demand for money are not offset by

a corresponding benefit. As such, ME theorists hold that a system under which the supply

of money could be reliably counted on to respond to changes in the demand to hold

money would be much preferred over a system where the price level bears the burden of

adjustment.

The monetary equilibrium approach should not be confused with the standard

neoclassical position of price level stability. Both the Rothbardian and ME approaches

recognize that prices—and, as a result, the aggregate price level—should fall in response

to increases in productivity. Similarly, if goods become more scarce on average—as a

result of a natural disaster, for example—the aggregate price level should increase to

reflect this. ME theorists do not advocate stabilizing an aggregate price level. Rather,

they suggest changing the money supply to offset changes in money demand and

allowing the price level to move inversely to changes in productivity. One can

characterize this as a desire to keep the MV side of the quantity equation constant, and

allow P to move inversely to Y. It is from this perspective that we consider the events of

the last few years and offer policy recommendations for the present and future.

Our approach finds its roots in the work of Knut Wicksell, Ludwig von Mises,

and Friedrich A. Hayek.2 These authors claimed that an excess supply or demand for

money causes the market rate of interest—that is, the rate that banks charge on loans—to

2 Intellectual predecessors also include American economists Harry G. Brown, Herbert J. Davenport, and Clark Warburton; the English economist Dennis H. Robertson; and the South African economist William H. Hutt.

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diverge from the Wicksellian natural rate of interest.3 Entrepreneurs react to these faulty

price signals by altering their investments, lengthening or shortening the production

process in line with the prevailing interest rate. The resulting malinvestments—to use the

Austrian term—are fundamentally at odds with the underlying time preferences of

individuals and will eventually reveal themselves as mistakes, leading to the process of

self-correction that is the recession that follows the boom.

We argue that the primary source of business fluctuation observed over the last

decade is monetary disequilibrium. Additionally, we claim that unnecessary intervention

in the banking sector distorted incentives, nearly resulting in the collapse of the financial

system, and that policies enacted to remedy the recession and financial instability have

likely made things worse. Finally, we offer our own prescriptions to reduce the likelihood

that such a scenario occurs again. Those come in two stages. First we suggest some

changes to the way monetary policy and banking regulation are conducted under the

assumption that we continue to have a central bank in more or less the form that the

Federal Reserve System takes in the United States. We conclude by offering a more

radical solution that involves a change in the monetary regime, specifically a move

toward a truly competitive free-banking system.

Banking Gone Awry

The origins of the Great Recession in the housing market have been well

documented. Austrian economists have consistently argued that excessively expansionary

3 As Horwitz (2000: 77) explains, “the inflationary disequilibrium theory that emerged from Wicksell’s work was the Austrian theory of the business cycle in the hands of Mises and Hayek.”

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monetary policy generated a credit boom while a series of regulatory and institutional

interventions encouraged the resulting malinvestment to concentrate in the real estate

sector of the economy.4 Policy errors—not a market gone mad—created a bubble that

eventually had to burst.

Virtually no one denies that Congress aggressively sought to promote

homeownership. The Federal National Mortgage Association (Fannie Mae) and the

Federal Home Loan Mortgage Corporation (Freddie Mac) were instructed by Congress to

increase the number of mortgage loans extended to low-income families under both

Clinton and Bush administrations (Schwartz 2009: 20). Furthermore, government

agencies dominated the mortgage securitization market, increasing the number of

securitized mortgages at a rate much greater than nongovernment agencies in the first

half of the decade (Horwitz and Boettke 2009: 8). But these facts merely explain why

errors clustered where they did. The underlying reason for these errors, regardless of

where they would turn up, was too-easy monetary policy.5

Although the Fed let interest rates fall below recommended Taylor-rule levels,

especially from 2002 to 2004, it is difficult to convincingly demonstrate that monetary

policy was too easy or too tight because the natural rate of interest is not directly

4 Essays from Austrian economists on the Great Recession include Boettke and Luther (2009), Horwitz and Boettke (2009), Horwitz (2009a), Horwitz (2009b), White (2008), and White (2009), among others. See also the historian Tom Woods’s (2009) book, which makes use of Austrian school theory. 5 In a recent interview with Brian Carney (2008), Anna Schwartz implicitly endorsed the Austrian theory of the trade cycle: “If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it’s so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.”

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observable (Taylor 2009a: 2). Beckworth and Selgin (2010: 5) provide a “crude estimate”

of the natural rate. Assuming that population growth and household time preference rates

are constant, they estimate the natural rate of interest as the long-run average real rate

plus the difference between the currently forecasted and mean total factor productivity

(TFP) growth rates. The measure created by Beckworth and Selgin (2010: 13) “suggests

that monetary policy was excessively easy in the aftermath of the dot.com collapse, and

that it was so to an extent unmatched since the inflationary 1970s.” Specifically, they

show that the estimated natural and actual real federal funds rate began diverging in 2001

and, in 2004, the actual real federal funds rate was 5 percentage points lower than the

estimated natural real federal funds rate (6). While their measure of the natural rate is

admittedly imperfect, the magnitude of the difference leaves little doubt that monetary

policy was excessively expansionary over the period.

Although there is a growing consensus that the Federal Reserve held interest rates

too low for too long, some continue to argue to the contrary. Hummel and Henderson

(2008: 2) reject the Austrian account, denying that monetary policy under Greenspan was

too loose. They claim a central bank’s ability to affect interest rates “is increasingly

diminished, even for a major central bank like the Fed, as globalization integrates global

financial markets” (3). Low interest rates, according to Hummel and Henderson, merely

reflect a rapid increase in the supply of loanable funds brought about by savings from

developing Asian economies.6

The Hummel-Henderson hypothesis is plausible, but empirical evidence suggests

it is incorrect. As Taylor (2009b: 348) notes, “a good fraction” of the European Central

6 This position is consistent with Greenspan’s (2007: 385–88 and 2008) own claim that emerging economies created a savings glut.

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Bank’s “interest rate decisions can be explained by the influence of the Fed’s interest rate

decisions.” Hence, the evidence suggests that central banks around the world look to the

Fed as the authority on optimal monetary policy. And while one central bank may play

but a small role, several banks acting erroneously in concert could have a destabilizing

effect. Furthermore, global savings as a share of GDP was lower in the 2002 to 2004

period than the thirty-year average from 1970 to 2000 (Taylor 2009b: 345–46). And that

global savings was less than investment for the period suggests a shortage—one we

contend was brought about by monetary expansion—rather than a glut.

L. H. White (2008) provides even more evidence in conflict with the Hummel-

Henderson hypothesis. If monetary expansion under Greenspan was not excessive,

changes in the stock of money would have merely offset changes in velocity and,

according to the equation of exchange, nominal spending would have been stable. Using

the growth rate for final sales of domestic goods, White (2008: 117) shows that nominal

spending increased rapidly from a compounded rate per annum of 3.6 percent between

2001 and 2003 to 7.1 percent between 2004 and 2006. As a result, Selgin (2008) remarks

that “whatever M was up to during the housing boom, it was not simply adjusting so as to

offset opposite changes in V.”

Although the Fed may be wholly to blame for creating the bubble, it is not

entirely responsible for the widespread bank failures and the financial meltdown that was

purportedly staved off in 2008. The housing bubble merely strained an already weak and

fragile banking system crippled by perverse incentives. Specifically, we argue that

federal deposit insurance and an implicit promise to bail out financial firms plagued the

banking sector with moral hazard.

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The Federal Deposit Insurance Corporation (FDIC) was created by the Banking

Act of 1933 (Glass-Steagall). The economic argument for deposit insurance is relatively

straightforward. In a fractional reserve system, lack of confidence can cause depositors to

run on a bank. If this lack of confidence is unfounded, a solvent bank could be rendered

insolvent through no fault of its own. Guaranteeing deposits provides depositors with the

confidence necessary to prevent bank runs. However, it also discourages depositors from

rewarding a prudent bank by accepting a lower rate of return. Since risky banks are then

able to draw in insured deposits without paying the risk premium it would have to pay if

depositors were still risk sensitive, deposit insurance effectively amounts to a subsidy for

bank risk-taking.

In order to mitigate this problem, Glass-Steagall placed restrictions on banks

receiving deposit insurance. Although investment banks would not be subject to the

additional restrictions, deposits at investment banks would not be federally insured and,

hence, individuals with deposits at investment banks would have to keep a close eye on

their balance sheets. Commercial banks, on the other hand, would receive deposit

insurance. And since individuals no longer have an incentive to monitor the bank once

their deposits are insured, FDIC was charged with the task of ensuring that these banks

were run prudently. Gorton (2010) argues that the geographic restrictions on banks in

place until the 1990s created local monopoly power that enhanced the value of a bank

charter, creating incentives for banks to avoid the risky behavior we would normally

expect with deposit insurance. In addition to the FDIC attempts at monitoring, the

complex set of government regulations actually interacted in a way that solved the

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principal-agent problem, though not without other costs to consumers and economic

efficiency thanks to the geographic restrictions and other regulations.

The Riegle-Neal Act of 1994 effectively ended many of the geographic

restrictions on banks. As the monopoly profits associated with bank charters fell, the

incentive for banks to avoid excessive risk declined as well. To make matters worse,

Congress tore down the wall between investment and commercial banks in 1999 by

passing the Financial Services Modernization Act (Gramm-Leach-Bliley). Gramm-

Leach-Bliley allowed commercial and investment banks to merge. FDIC would still

insure commercial deposits, but they would no longer prevent banks holding commercial

deposits from taking on excessive risk. Without monopoly profits, bankers were no

longer encouraged to act prudently under this system. Depositors with insured accounts

had no incentive to watch the banks. Regulators were no longer concerned with moral

hazard. And taxpayers—who would ultimately be on the hook if the Deposit Insurance

Fund7 fell into the red—were in the dark. Unsurprisingly, banks leveraged up.

To make matters worse, historical experience had revealed to banks that the

federal government would bail them out if they got into trouble. Direct bailouts first

became a policy option in the United States with the Federal Deposit Insurance Act of

1950, which allowed the FDIC to provide emergency assistance to banks deemed

“essential to provide adequate banking service in its community.” It used this authority

for the first time in 1971 by bailing out Unity Bank in Boston (Hetzel 1991: 5). In 1984,

it demonstrated the extent of its support by infusing an unprecedented $4.5 billion into

7 From 1989 to 2006, FDIC managed two funds: the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). These funds were merged in 2006 to create the Deposit Insurance Fund (DIF) when President Bush signed the Federal Deposit Insurance Reform Act of 2005 (FDIRA) into law.

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the failing Continental Illinois National Bank and Trust Company. Then, in 1999, the Fed

reaffirmed the federal government’s commitment to backing insolvent institutions by

orchestrating a bailout for Long-Term Capital Management.8 These actions gave banks

an implicit guarantee that, should they find themselves in a pinch, the government would

cover the losses. With risk effectively subsidized and gains privatized, these financial

institutions took risks they otherwise would have avoided.

The U.S. government had made it quite clear it would cover the costs if major

banks were in trouble—a promise it largely kept. And banks responded accordingly. Too-

big-to-fail and too-many-to-fail doctrines encouraged banks to consolidate and employ

similar strategies.9 Government backing—in terms of deposit insurance and an implicit

guarantee to bail out banks—meant that the American taxpayer would ultimately foot the

bill if losses were incurred. It was as if we sent the CEOs of the world’s largest financial

firms to Las Vegas with Uncle Sam’s credit card to cover their losses and told them they

could keep their winnings. Predictably, they made very risky bets that would make them

unbelievably wealthy in the improbable event that they panned out. But those bets did not

pan out.

It All Came Crumbling Down

In 2004, the federal funds rate began to converge toward the natural rate as

estimated by Beckworth and Selgin (2010: 6) and the bubble began to burst. Housing

prices—having been bid up in the boom—reached their peak in 2005 and started to fall.

8 Dowd (1999) discusses the failure and rescue of LTCM. 9 Stern and Feldman (2004) provide a comprehensive analysis of the too-big-to-fail doctrine. Acharya and Yorulmazer (2007) show that the too-many-to-fail results in herding, particularly among smaller banks.

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Mortgage defaults increased. By the end of the second quarter of 2006, foreclosures sat

50 percent higher than in 2002. Financial giants like Bear Sterns and Lehman Brothers

watched as the value of their assets collapsed. Investing heavily in mortgage-backed

securities had been lucrative for a while, but ultimately turned out to be a losing strategy.

On October 17, 2007, then-Treasury Secretary Henry Paulson declared that the housing

decline was “the most significant current risk to our economy.” And everyone seemed to

be asking the same question: what can we do about it? Virtually no one wondered if we

had done too much already, or whether the best solution was to allow prices to get

themselves in line with the underlying variables.

Fearing a repeat of the deflation of the early 1930s, the Fed rapidly expanded the

monetary base to offset what appeared to be a collapse in the money multiplier.10 From

September 2008 to May 2010, the monetary base increased by 138 percent, from $843

billion to $2,007 billion. Although increasing the monetary base would be necessary to

maintain monetary equilibrium if the money multiplier were falling, simultaneous

changes in other variables like velocity complicate the situation. As noted above, it is

difficult to know for sure whether the money supply is too big or too small under central

banking. It is true that nominal GDP growth—which averaged 5.7 percent a year from

1986 to 2006—began falling in 2007 and turned negative in late 2008, suggesting that

monetary policy was too tight. But if the last decade was marked by monetary expansion

(as we argue above), the 5.7 percent benchmark overstates the sustainable long-run GDP

growth rate. As such, the fall in nominal GDP growth might very well indicate the

10 Recall that in a fractional reserve banking system, M = Bm, where M is the money supply, B is base money, and m is the money multiplier. We return to the issue of central bank fear of deflation in a later section.

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inevitable return to the sustainable long-run trend. Whether the decline in nominal GDP

growth is evidence of monetary disequilibrium is harder to discern given that the prior

years of growth took place in an inflationary environment, but the magnitude of the

decline suggests that some increase in the monetary base over the past two years was

likely the appropriate response. Even if the Fed acted in the right direction, it is not at all

clear whether this expansion was too big or too small.

Any good the Fed’s monetary policy might have done has arguably been more

than offset by a plethora of policy errors. Acting in concert with the Treasury, the Fed

increased uncertainty by hosting secret meetings with key players in the banking system

and Washington, D.C. The political nature of these meetings made it difficult for

entrepreneurs to accurately assess their options. And the tone of fear established by top

Fed and Treasury officials decreased confidence among consumers and investors.11

Ironically, this frenzied response may have caused the very panic the Fed and Treasury

aimed to prevent.

Even though increasing uncertainty and perpetuating a climate of fear has almost

certainly had an impact on present conditions, other policy errors have the potential to do

significant damage over the long haul by amplifying the extent of moral hazard already

present in the system. For starters, the maximum deposit balance insured by FDIC was

increased from $100,000 to $250,000 in 2008, reducing the incentive for those with

deposits in excess of $100,000 to monitor banks even further. Similarly, the Treasury

extended deposit insurance to cover money market mutual funds. Although both of these

11 At a White House meeting held in September 2008, for example, then-Treasury Secretary Henry Paulson literally got down on one knee to beg House Speaker Nancy Pelosi to pass the Troubled Asset Relief Program (Herszenhorn et al. 2008).

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programs were initially purported to be temporary, whether or not they will actually be

rolled back remains to be seen.12 And, at the very least, they reaffirm a dangerous

precedent capable of increasing risk regardless of whether these particular programs are

officially terminated in the next few years.

The increase in moral hazard from deposit insurance likely pales in comparison to

that resulting from the bailouts offered over the last few years. When Bear Stearns

approached the brink in March 2008, the Fed lived up to expectations established in

dealing with Long-Term Capital Management. In exchange for purchasing Bear Stearns

for $2 per share—down from $93 in February 2008—the Fed extended a $30 billion

nonrecourse loan to JP Morgan. Having accepted Bear Stearns’ mortgage debt as

collateral, the Fed would have no recourse (i.e., it cannot seize any other assets from JP

Morgan) should the value of these so-called “toxic assets” fall below the value of the

loan. In other words, the Fed—and ultimately the taxpayer—bears the risk associated

with the bad loans while JP Morgan receives the benefits if things work out.

Unfortunately, deals like this abound. Congress set aside $700 billion for the

Treasury to dole out through the Troubled Asset Relief Program (TARP). By January

2009, the U.S. government had become a major shareholder in the banking system by

purchasing $178 billion worth of bank equity shares through the Capital Purchase

12 The temporary increase in FDIC insurance coverage from $100,000 to $250,000 per depositor as established in the Emergency Economic Stabilization Act of 2008 was originally schedule to expire on December 31, 2009, at which point coverage levels would return to $100,000. It was then rescheduled to last until December 31, 2013. The increase was made permanent with the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010.

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Program.13 $25 billion more was spent on preferred stock of Citigroup and GMAC.

Another $40 billion was used to buy up a large chunk of AIG. Tack on the $19.4 billion

spent to bail out the auto industry and $25 billion to backstop the Fed and guarantee loans

for Citigroup and—as Everett Dirksen might say—pretty soon you’re talking real money.

Although most of the money spent thus far has been to acquire stock (which can

eventually be resold) or issue loans (much of which has already been repaid), these

expenditures might still add to the growing government debt. The Congressional Budget

Office estimates that the subsidy cost of the $247 billion spent from October 2008 to

January 2009 amounts to roughly $64 billion (CBO 2009: 1). Worst of all, as Lawrence

Kotlikoff (2010: 92) argues, “Bailouts are teaching corporate America a very bad lesson

about looking to the government in times of trouble.” If Kotlikoff is correct—and if the

government does nothing to remedy the situation—moral hazard will be an even bigger

problem in the future.

Where do we go from here?

The desire to end the recession as quickly as possible has prompted the Bush and

Obama administrations to cut taxes and increase government spending. Unfortunately,

the best medicine for ending a recession is time. It takes time for capital to be retooled

and reallocated. It takes time for labor to learn new skills and relocate. And only in time

will entrepreneurs have enough information to feel comfortable pursuing new plans.

Efforts to jumpstart the economy prematurely by providing fiscal stimulus merely

interrupt and postpone the inevitable adjustment process. However, one thing

13 The Capital Purchase Program is a component of TARP allowing the Treasury to purchase preferred stock and equity warrants.

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policymakers can do is ensure that, when enough time has passed, market participants

will return to an institutional environment conducive to the market process. This requires

addressing two major problems moving forward: monetary instability and moral hazard.

In our view, monetary stability means continuously adjusting the supply of money

to offset changes in velocity.14 Given the current monetary regime, where such

adjustments are in the hands of the central bank, they should be made as mechanical as

possible. Discretionary monetary policy unnecessarily introduces instability into the

system with little or no offsetting benefit. Instead, the Fed should commit to a policy rule.

Given our monetary equilibrium view, we hold that the Fed should adopt a nominal

income target. Although nominal income targeting would require price adjustments in

response to changes in aggregate supply, these particular price changes convey important

information about relative scarcity over time and would be much less costly than

requiring all other prices to change as would be the case under a price-level targeting

regime (Selgin 1997: 23–29). Under a nominal income targeting regime, monetary policy

would have the best chance to maintain our goal of monetary equilibrium, at least to the

extent that central bankers can accurately estimate and commit to follow an aggregate

measure of output. As imperfect as this solution would be, we believe it is superior to the

14 As we shall discuss in the next section, we believe that a fundamental change in monetary regimes in the form of adopting a free-banking system is the first best way to achieve this end. Unfortunately, “a combination of governmental desire to manipulate money and economic theory favoring central banking led governments to replace competitive issue of notes (paper money) by commercial banks with monopoly issue by central banks” in the period since the start of WWI (Schuler 2001: 453). Given that these forces are still in play, abolishing the Fed and establishing a system of competitive note issue, though ideal, is likely out of the question, at least in the short run. This necessarily leaves us in a world of the second best.

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alternatives available in the world of the second best, and certainly an improvement over

the status quo of the Fed’s pure discretion in monetary policy and beyond.

A monetary regime that stayed closer to monetary equilibrium would have likely

prevented the housing bubble and subsequent recession. However, it is also important to

weed out the moral hazard problem perpetuated—and recently exacerbated—by nearly a

century of policy errors. Among other things, this means ending federal deposit insurance

and credibly committing not to offer any more bailouts. The political consequences of

such a policy are admittedly unclear. And the feasibility of credibly committing to refrain

from stepping in should a similar situation result, having just exemplified a willingness to

do precisely the opposite, does not look promising. Nonetheless, we contend that ending

the moral hazard problem is essential to long-run economic growth free of damaging

macroeconomic fluctuations.

The absolute worst solution in terms of dealing with moral hazard would be to

abolish these programs officially without credibly committing to refrain from

reestablishing them in the future. If market participants expect the government will bail

them out when they get into trouble, they will act accordingly. The difference, however,

would be that the Deposit Insurance Fund—having been abolished—would be empty and

the full cost of bailing out depositors would fall on taxpayers in general. If bailouts and

deposit insurance are going to be offered in the future, those likely to take advantage of

them should be required to pay into respective funds to be used when the occasion arises.

Ideally, payouts would be limited to the size of the fund. But given that a lack of

credibility is the only acceptable reason to perpetuate these programs, their continuance

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suggests that the resulting government would be unable to tie its hands in this capacity as

well.

We end our policy recommendations within the current monetary regime by

emphasizing our reluctance to keep FDIC or establish an official bailout fund. These

suggestions are clearly made in a world of the second best, where the government is

incapable of choosing our preferred alternative. In such a world, we argue that the

combination of the FDIC and a Deposit Insurance Fund drawn from the banks is

preferred to no official deposit insurance program and an implicit guarantee to be funded

by taxpayers in general when the need arises, with all the dangers of the political process

defining “need” that such a situation would bring. Similarly, we would prefer explicit

promises to bail out financial institutions via deposit insurance, and a corresponding fund

to provide the resources, to the implicit promises existing in our current system, provided

that the government is incapable of denying bailouts ex post regardless of their position

ex ante. Unfortunately, as Mises (1996: 8) pointed out, interventions typically have

unintended consequences that run counter to their desired goals, and “[i]f government is

not inclined to alleviate the situation through removing its limited intervention [. . .] its

first step must be followed by others.” The interventions we might reluctantly accept here

are no different.

Mitigating the moral hazard associated with continuing federal deposit insurance

and establishing an official bailout fund would likely require raising capital requirements

and overseeing financial services to an even greater extent in the future. With the

prospect of regulatory capture at one end and a bureaucratic banking system at the other,

this is obviously the least desirable of the potential alternatives we outline. In the world

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of the second best, a deposit insurance system sufficiently funded by the banks might be

better than perpetuating a system that fully socializes costs while privatizing gains, as a

greater share of the costs of bailing out failed banks are borne by banks and depositors

rather than taxpayers broadly. These dilemmas of the second-best world further

emphasize that the ultimate solution to the problems of the Great Recession is to remove

the whole panoply of government interventions that caused it, with the Federal Reserve

System being first and foremost among them. In the final section we explore what the

free-banking alternative might look like and why it offers a first-best solution.

The Free-Banking Alternative

Normally, the only alternative to central banking that receives real consideration

is some kind of commodity standard, not unlike what the classical gold standard of the

nineteenth century. There was much to recommend about that system, but in practice, it

never gave the full play to market forces that is required to minimize deviations from

monetary equilibrium. Under a commodity standard, the supply of money expands and

contracts more or less the way monetary equilibrium theorists claim is desirable.

Consider the automatic response under a gold standard to a sudden increase in the

demand to hold money.15 The increase in demand puts upward pressure on the purchasing

power of gold. As a result, some individuals currently using gold in other, nonmonetary

capacities (e.g., jewelry, candelabras) will choose to melt and mint, unintentionally

increasing the quantity of money in circulation. Furthermore, mine owners are

15 White (1999: 28–37) graphically details the automatic mechanism underlying the classical gold standard.

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encouraged to increase their production of gold. With more gold being produced, the

money supply expands until the purchasing power of gold is restored to its original level.

The advantage of such a system is that the supply of the commodity serving as

money responds to offset changes in money demand. Unfortunately, it does not do so

very rapidly. The process of converting the commodity from nonmonetary sources and

mining is very time consuming. Although precise estimates are not available, the

adjustment process of the historical gold standard, White (1999: 38) claims, “probably

required a decade or more on average.” With changes in the money supply delayed by a

decade or more, changes in velocity make aggregate demand unstable. As a result, prices

and output fluctuate and generalized economic discoordination abounds.

An alternative monetary regime, normally referred to as “free banking,” has the

potential to adjust more rapidly. Under free banking, private banks create money, both in

deposit and currency form. Both forms of bank liabilities would be redeemable in some

outside money, mostly likely a commodity such as gold. Prior to the creation of central

banks, this was the typical way in which both deposits and currency were produced. In

the more successful of these systems (e.g., Canada and Scotland), banks were left free to

produce their liabilities to the best of their judgment. In other systems, such as the United

States, other forms of government regulation (e.g., limits on branch banking and

requirements to hold federal government bonds as collateral against currency issues)

prevented banks from making the appropriate adjustments in the money supply. In a truly

free banking system, banks would be left to determine the quantity of money (in the form

of bank liabilities) they create based on their calculations of profit maximization. What

free-banking theorists argue is that the profit-maximizing quantity of bank liabilities to

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create is that quantity that meets the demand to hold those liabilities at the current price

level. In other words, profit-maximizing banks will maintain monetary equilibrium.16

The key to that result is the calculation banks make about their holdings of

reserves. Free banks would determine their reserve holdings at the clearinghouse and in

their vaults by balancing the risk of being illiquid in the face of demands for redemption

against the opportunity cost of foregone interest from the loans those reserves could

support. If such a bank creates more liabilities than the public wishes to hold in their

money balances, those excess liabilities will be spent and eventually come back to the

issuing bank for redemption. Whether that redemption is “over the counter” for the

outside money commodity or, more likely, through the clearing system by other banks, it

will reduce the issuing bank’s holding of reserves. If we assume the bank was

maximizing profits before the overissue, then this loss in reserves means a loss in profits

and the bank will have both the signal (in the form of reduced reserves) and the incentive

(in the form of lost profits) to reduce its liabilities back to that amount the public wishes

to hold. Conversely, should it issue too few liabilities compared to demand, it will see

reserves piling up as redemptions fall. Those excess reserves reflect an opportunity cost

in terms of foregone interest on loans that could be made with them, just as is true in

banking systems today. The profit-maximizing free bank would see that signal and

recognize the incentive to increase its liability issuance to provide the amount the public

wishes to hold. Profit maximization produces monetary equilibrium.

What is true of the free bank misjudging the quantity of money its customers want

to hold is equally true of how it will respond to a change in consumer demand for its

16 Selgin and White (1994) detail the mechanics of free banking in much greater detail. The interested reader should also consult the sources referenced there.

21

liabilities. Bank customers express their new demand to hold money by spending less. As

a result, fewer notes are redeemed directly and through the clearinghouse system, just as

we saw above when the bank issued too few liabilities in the face of a constant demand

for money. Assuming that banks were optimizing subject to consumer preferences prior

to the change in demand, they now find that their reserves are in excess of that amount

required to maintain liquidity and that the bank is forgoing interest returns it could safely

be earning. The profit motive directs each individual bank to expand the number of loans

and securities it holds until reserves are reduced to the new equilibrium level. In the

aggregate, the money supply is expanding to match the increase in money demand. And

since individual banks need only print up more of their notes or credit electronic

accounts, the supply of money can adjust much more rapidly in comparison to a strict

commodity standard.

Absent a free market in money and banking, the supply of money must be

consciously adjusted by a central bank if monetary equilibrium is to be maintained.

Compared to free banking, central banks face at least three problems in conducting

optimal monetary policy. First, they do not have access to the information that is readily

available in the form of market prices to gold miners and bankers in the two regimes

discussed above. Instead, the central bank must rely on costly aggregate data sets that

arguably hold less informational content in comparison to prices. That these data sets

become available to the central bank with a significant lag is also problematic, as it

means they often do not know an adjustment is necessary until the very events the

adjustment might have prevented begin to materialize. Relying on changes in

22

macroeconomic aggregates to signal the need to change the money supply to prevent

changes in those very aggregates seems an unsolvable problem.

In addition to the information problem, central banks do not face the same

incentives as private participants. Under free banking, for example, an overissuing bank

would suffer reserve losses when adverse clearings manifest at the clearinghouse.

Although a similar incentive might exist if politicians lose votes for continuously

appointing highly inflationary central bankers, this incentive appears to be much weaker

than those faced by market participants in alternative regimes.17 After all, the U.S. public

debt currently exceeds $13 trillion. As the world’s largest debtor, the U.S. government

stands to gain from a little unexpected inflation.

Finally, the monopoly status of central banks amplifies errors. Under a

competitive free-banking system, where an individual bank might maintain only 20

percent of the total circulation, any single bank’s overissuing by 10 percent would only

result in a 2 percent overissue in the aggregate. Furthermore, this error could potentially

be offset by the underissuing of another bank. Central banking, on the other hand, assigns

the entire task of getting it right to a single central planner.18 There is no possibility of

offsetting errors, and a 10 percent overissue by the single bank is a 10 percent overissue

by the banking system.

The early history of the central bank illustrates its potential for blunders. While

productivity soared in the 1920s, for example, the Fed overexpanded the money supply,

17 The implicit promise by free banks to maintain monetary equilibrium is self-enforcing via profit and loss, while any explicit promise by central banks to do so lacks the incentive compatibility necessary to enforce such a promise. 18 If equating central banking to central planning seems unwarranted, recall that former Fed Chairman Alan Greenspan was affectionately called “The Maestro.”

23

resulting in a relatively constant price level.19 It would be the error at the end of the

decade however that would stand out in the twentieth century. As Friedman and Schwartz

(1963: 299–407) detail, the money supply contracted by roughly a third from 1929 to

1933 because the Fed did not respond as it should have.20 Had the Fed maintained

monetary equilibrium, the period now know as the Great Depression might have turned

out to be a garden-variety recession, along the lines of, though perhaps somewhat more

severe than, the 1920–21 recession. Instead it became the worst economic crisis in U.S.

history.

Because central bankers fear nothing more than being seen as responsible for

another Great Depression, they have erred in the opposite direction of the deflationary

mistakes made in the early 1930s. Selgin and Beckworth (2010: 1) show that—as was the

case in the 1920s—the Fed’s “occasional, unintentional exacerbation of the business

cycle is largely attributable to its failure to respond appropriately to persistent changes in

the growth rate of total factor productivity.” Specifically, when factor productivity

growth is high and monetary equilibrium theory would require a falling price level, the

Fed expands the money supply to prevent prices from falling. In doing so, the Fed pushes

the federal funds rate below the natural rate and leads entrepreneurs to generate

19 The Board of Governors of the Federal Reserve System (1937: 827–28) ultimately admitted to this error in describing monetary policy objectives: “No matter what price index may be adopted as a guide, unstable economic conditions may develop, as they did in the 1920s, while the price level remains stable; business activity can change in one direction or the other and acquire considerable momentum before changes are reflected in the index of prices. There are situations in which changes in the price level work toward maintenance of stability; declining prices resulting from technological improvements, for example, may contribute to stability by increasing consumption.” 20 The Fed’s inaction was a result of the combination of (1) not quite understanding the dimensions of the problem; (2) holding to an incorrect monetary theory, in the form of the Real Bills Doctrine, that led many members to recommend a wrong cure; and (3) to the extent other voices had it right, their recommended actions were too little, too late.

24

malinvestment. Fearing deflation, the Fed consistently overexpands the money supply

with little regard for the ill effects.

One other explanation for the inflationary bias of the Fed is that the costs of

inflation are far more subtle and long run than those associated with deflation. The ways

in which inflation plays havoc with prices and disrupts microeconomic coordination and

entrepreneurship are widespread and hard to connect directly to the inflationary activities

of the central bank (Horwitz 2003). In contrast, deflation usually makes itself known

quickly, as the shortage of money begins to reduce the number of mutually beneficial

exchanges that take place, which in combination with prices not falling immediately

leads to surpluses of goods and labor. The shortage of money is felt acutely and its effects

can be tied back to that cause. Not only does inflation benefit governments by reducing

the real burden of their debt, it is politically less costly to the central bank directly, as its

consequences cannot easily be connected with its cause.

The Fed’s fixation with deflation was perhaps best exemplified in a November

2002 speech by then-Governor Ben Bernanke. Honoring Milton Friedman on his

ninetieth birthday, Bernanke (2002) made it clear that those at the Fed understood the

lesson of the Great Depression. He ended his talk by “abusing slightly” his “status as an

official representative of the Federal Reserve” to address Friedman and coauthor Anna

Schwartz directly with the following words:

Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Since being appointed chairman of the Fed in 2006, Bernanke has made good on his

promise. Unfortunately, he has followed many of his predecessors in making precisely

25

the opposite error, setting the stage for the current recession and financial market

instability.

The structure of a free-banking system not only eliminates these destructive

incentive and information problems, it replaces both with market signals that provide the

needed information wrapped in the necessary incentives, with the result that the banks’

incentives are aligned with the goal of maintaining monetary equilibrium. Although such

a dramatic change in monetary regimes may not be politically feasible in the near future,

especially because central banks are very useful for governments that are trillions in debt,

the increasing public scrutiny that the Fed and other central banks are under is one reason

to continue to argue for a fundamental change in regimes. As we have argued, central

banks along with other forms of government intervention have given us the Great

Recession. It seems only fair that all of the parties responsible for the current mess be

subject to equal critical scrutiny and that those who wish to avoid further damage to the

world economy be willing to put on the table every proposal they believe will help,

regardless of whether it is currently politically possible. Serious economic problems

require the courage of radical, and potentially unpopular, solutions.

26

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